Fool Portfolio Report
Friday, January 23, 1998
by Jeff Fischer (JeffF@fool.com)

ALEXANDRIA, VA (Jan. 23, 1998) -- Not a pretty week for the Fool Port, unless you like the color red. The S&P and Nasdaq ended relatively flat over the past four trading days, while the Fool lost a big 4.5% thanks mainly to Iomega (and minorly to Trump).

This week made a Fool appreciate companies like 3Com that announce earnings on a different cycle than every other company on earth. Over the past four days KLA-Tencor, Innovex, Lucent, and Chevron all reported earnings that were at least in line with estimates. We covered the first three companies on Tuesday, and then on Thursday Iomega and Amazon announced results. I promised closer looks at those two companies to wrap up the week.

Writing about Iomega (NYSE: IOM) in a column format within the Motley Fool, though, is akin to standing atop a mountain and calling yourself ruler while thousands of more informed individuals stand below you and share all of the facts among themselves. The Iomega message boards are heady with discussion following Thursday's earnings report. For the most thorough reflections from Fools closely involved, you're best off hitting the boards (some of the best board posts are capsulized in "Iomega in Fooldom"). Afterall, my thoughts are those of just one person. But here are some of them.

Management didn't perform up to snuff in at least two areas:

1. The earnings surprise should have been preannounced, in my opinion, with damage control to the effect that estimates would have been met if not for the recent share dilution.

and...

2. The general business operation was obviously less than satisfactory. Several products were delayed during the quarter for various reasons, while component shortages continued to plague the company as they have since 1995.

The Iomega conference call was rich in detail, including information on the delay of the Zip Plus, Jaz 2, Ditto, and Buzz product lines during the quarter. The company said product delays lowered revenues by about $70 million, while Asian currency woes supposedly decreased revenue by $50 million (this is a figure that I might question, because revenue in Asia was actually up 88% year over year, not at all horrible. Could Asia be a scapegoat?) A larger concern than Asia -- despite the company's press release -- is America. Domestic sales only grew to $301 million from the $287 million achieved in the previous quarter.

Operating margins fell in part because original equipment manufacturer (OEM) sales (which are sales to computer manufacturers) now constitute a much larger percentage of revenue than they had in the past, compared to retail sales. OEM sales have lower margins and lower tie rates (meaning, when internal Zip drives are bought, the customer typically buys fewer Zip disks than does a customer who buys an external Zip drive from a retail shelf). OEM sales accounted for 34% of revenue compared to just 10% in the same quarter of 1996. This is a natural result of business progress, so treating it as an "excuse" for lower margins and fewer disk sales is an interesting dilemma.

Most of the delayed products mentioned above are now shipping in volume, but Jaz 2 is yet to be released and notebook OEM Zip drives will begin to sell after the second quarter. In order to increase Zip sales in general, the company is launching a new ad initiative and plans to spend $100 million this year, with Super Bowl ads airing on Sunday for starters. At the conference call it was asked if the company would do better to cut prices in order to increase sales, but Iomega responded that consumers need to know about a product before price cuts mean anything to them, and sales now, before price cuts, are of course preferred. The company still intends to lower the Zip price to $99 when the time is right. It almost needs to lower prices, as additional storage space of other kinds is consistently becoming less expensive.

But where does all of this leave margins? The spectre of increased ad spending alongside with recently increased expenses and slowing domestic revenue growth muddies the margins and earnings scenario for the year.

Thursday I wrote, based on thumbnail projections, that much of the downside risk was possibly removed from the stock following the sharp decline, but actually that depends on what kind of valuation a storage technology company deserves. For the most part, industry stocks typically trade at price-to-earnings multiples well below growth rates (once a business niche within the industry matures). Iomega is different because it sells the disks, not just the drives, but how different is it? At the conference call, brand name was mentioned several times, as was the installed base of users -- both of which are definitely valuable. But Apple Computer had an impressive installed base of users a long time ago, too. (That comment was basically meant to rile Iomega fans. Here comes the flame mail!)

What Iomega has done is create very popular portable storage products that cover all consumer market segments and four different technology platforms. The company has done an incredible job, and without suffering many glitches (except for the too frequent component shortages and the not so atypical quality delays). But arguably what Iomega needs to accomplish in order to continue growing at a sustainable market-beating pace is being challenged on a few fronts. On one hand, its OEM success is biting into margins. On the other hand, in order to increase retail sales, which have higher margins, Iomega needs to increase advertising or decrease prices, both of which will deflate margins, too.

Finally, the share dilution and stock split seem excessive. Of course, all companies that wish to retain and motivate talented employees need to issue enough equity to those individuals. That's obvious. Equity is a risk-embodied incentive that needs to be issued in amounts above the current perceived value in order to compensate for the risk. Without having Iomega's option payments in front of me, it seems that the company is issuing equity in generous amounts that are usually reserved for small start-up companies that hold a great deal of risk and have the most to lose (or gain) by motivating or not motivating employees -- and that can't afford to pay higher salaries. Two cents per share in earnings dilution is pretty significant with 260 million shares outstanding.

Meanwhile, Dale Wettlaufer (TMF Ralegh) and I agree that the stock split didn't make much sense in the low $20s. We now have a stock trading on the NYSE below $9 per share. A decline of a few more dollars and we have an embarrassing stock price that institutional investors might hesitate to consider. The company probably could have waited until the annual shareholders meeting and authorized an increase in the number of shares through other means rather than splitting the stock yet again to accommodate for options granted.

The week was a busy one elsewhere, though, and I apologize for writing for two days on Iomega alone. AT&T was upgraded this week, Amazon was initiated with a "buy" rating on Thursday, and Iomega was downgraded on Friday. Finally, Trump rose on rumors that the company may restructure itself into a real estate entity, or sell property, or refinance debt... rumors. We'll see. Anyway, we need to take our look at Amazon's earnings next week instead of today. My apologies for the delay. Let's not sweat it. Instead...

...enjoy the Super Bowl this weekend! While Mr. Self-Proclaimed Cheeze-Head is cheering for Green Bay, I've got to hope for the underdog, Denver. You'll enjoy the big game more if:

1. You watch for the Iomega commercials. (With Iomega inventory built up, at least Zip drives exist to meet demand following the advertising.)

and...

2. You'll have much more fun if you play FoolBall first. There are prizes involved and it's easy, fun and funny, and it makes the game more interesting. Wives, if your husband is insistent on watching the game, at least have a FoolBall checklist to play along with. And good luck...

Message board links to Iomega, and to Amazon.com.

--J. Fischer

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TODAY'S NUMBERS

Stock Change Bid ---------------- AMZN -2 3/8 59.25 AOL - 3/16 95.25 T - 3/8 65.38 CHV -1 7/16 74.00 DJT + 1/2 9.13 GM - 5/16 57.06 INVX + 3/16 21.13 IOM - 5/16 8.81 KLAC +1 7/16 37.56 LU - 5/16 83.00 MMM + 13/16 81.56 RTN.A - 3/4 49.06 COMS - 1/8 30.88 TDFX - 3/4 23.13 SPY - 9/64 95.94
Day Month Year History FOOL -1.47% -7.22% -7.22% 211.36% S&P: -0.57% -1.32% -1.32% 108.90% NASDAQ: -0.04% 0.36% 0.36% 118.82% Rec'd # Security In At Now Change 8/5/94 355 AmOnline 7.27 95.25 1209.66% 5/17/95 1960 Iomega Cor 1.28 8.81 588.26% 10/1/96 42 LucentTech 47.62 83.00 74.31% 8/12/96 130 AT&T 39.58 65.38 65.18% 9/9/97 290 Amazon.com 38.22 59.25 55.02% 8/11/95 125 Chevron 50.28 74.00 47.16% 8/12/96 110 Minn M&M 65.68 81.56 24.19% 8/12/96 280 Gen'l Moto 48.74 57.06 17.07% 1/8/98 115 S&P Depos. 95.91 95.94 0.03% 4/30/97 -1170 *Trump* 8.47 9.13 -7.75% 12/19/97 17 Raytheon 53.21 49.06 -7.79% 1/8/98 425 3Dfx 25.67 23.13 -9.91% 8/24/95 130 KLA-Tencor 44.71 37.56 -15.99% 6/26/97 325 Innovex 27.71 21.13 -23.76% 8/13/96 250 3Com Corp. 46.86 30.88 -34.12% Rec'd # Security In At Value Change 8/5/94 355 AmOnline 2581.87 33813.75 $31231.88 5/17/95 1960 Iomega Cor 2509.60 17272.50 $14762.90 9/9/97 290 Amazon.com 11084.24 17182.50 $6098.26 8/12/96 130 AT&T 5145.11 8498.75 $3353.64 8/11/95 125 Chevron 6285.61 9250.00 $2964.39 8/12/96 280 Gen'l Moto 13647.92 15977.50 $2329.58 8/12/96 110 Minn M&M 7224.44 8971.88 $1747.44 10/1/96 42 LucentTech 1999.88 3486.00 $1486.12 1/8/98 115 S&P Depos. 11029.25 11032.81 $3.56 12/19/97 17 Raytheon 904.57 834.06 -$70.51 4/30/97 -1170*Trump* -9908.50 -10676.25 -$767.75 8/24/95 130 KLA-Tencor 5812.49 4883.13 -$929.37 1/8/98 425 3Dfx 10908.63 9828.13 -$1080.50 6/26/97 325 Innovex 9005.62 6865.63 -$2140.00 8/13/96 250 3Com Corp. 11715.99 7718.75 -$3997.24 CASH $10740.46 TOTAL $155679.58